Thursday, September 20, 2012

QE3 and The Fed's Shaping of Global Monetary Policy

One overlooked consequence of QE3 is that it has the ability to restore robust nominal spending not only in the United States but also in the world. This is because the Fed is a monetary superpower:

The Fed has this power because it manages the world's main reserve
currency and many emerging markets are formally or informally pegged to
dollar. As a result, its monetary policy gets exported to much of the
emerging world. The ECB and Bank of Japan are also influenced by the
Fed's decisions because they are careful not to let their currencies
becomes too expensive relative to these dollar-pegged currencies and the
dollar itself. U.S. monetary policy, consequently, gets exported to
the Eurozone and Japan as well.

This understanding helps explains why there was a global liquidity glut
during housing boom period and suggests that some of the "global saving
glut" was simply a recycling of loose U.S. monetary policy. It also
implies that the Fed could now do a lot of good
for both the U.S. and Eurozone economies if were to adopt something
like a NGDP level target. Based on this view, the global economy sorely needs the Fed to wake up from its slumber.

Well, it seems that QE3 is already beginning to shape global monetary conditions as the WSJ now reports:

Massive injections of stimulus into financial markets by the world's largest central banks are creating a domino effect around the globe, prompting governments from Brazil to Turkey to take steps to keep easy money from flooding in and driving up their currencies.

The Bank of Japan Wednesday became the latest central bank to ease monetary policy. That follows bold pledges by the world's two biggest central banks to launch open-ended programs to bolster their economies.

[...]

"All of this cash generated by the Federal Reserve is going to be entering foreign shores," said Komal Sri-Kumar, chief global strategist at TCW. "Emerging markets are going to be tempted to cut interest rates…to offset their currencies appreciating too much."

For the same reason, QE3 will also put pressure on the ECB and the Bank of England to keep easing. Now some observers like the BIS will find the Fed's loosening of global monetary conditions troubling. They shouldn't. The world currently faces a shortage of safe assets--or an excess global demand for money--that is undermining the recovery of the world economy. This shortage is also why global interest rates are depressed and the real reason why savers, investors, and financial intermediaries are suffering from the compressed yield curve.

QE3 has the potential to change this. It can raise expected future nominal incomes across the world by loosening global monetary conditions. This, in turn, should increase the demand for financial intermediation today and incentive the private sector to start
producing more safe assets. The demand for safe assets would therefore be better satiated and at the same time reduced by the increased certainty of future nominal income streams. The expected higher nominal incomes and the increased demand for credit this would create would also raise safe asset interest rates across the globe and therefore help savers and investors.

Of course, this happy ending is predicated on the Fed turning QE3 into something more explicit like a NGDP level target. Doing so would better manage nominal income expectations and allow monetary policy to pack more of a punch. Evan Soltas makes the case that just such a progression is a likely outcome. I hope so. In the meantime it will be interesting to see how QE3's influence on global monetary conditions unfolds.

P.S. George Selgin rightly warns that the QE3 as is has the potential to go very bad. That is why I want the FOMC to proceed forward to a NGDP level target. It would make the Fed more accountable, more systematic, and a better anchor of long-run inflation expectations. See Scott Sumner, Lars Christensen, and Bill Woosley for related discussion.

Those critics miss something important: creating money is only inflationary if it leads to a more more money than is desired. In other words, these critics only look at money supply and ignore money demand. And right now money demand is highly elevated and depressing aggregate nominal spending.